Please note that the commentary is for the retail class of the fund. The financial sector provided little in the way of return for the third quarter, consistent with the broader market. The fund returned 1.7% for the quarter, outperforming the benchmark return of 0.9%. Over the more meaningful three, five and ten-year periods the fund has generated annualised returns of 11.0%, 18.2% and 13.7%, compared with that of the index of 13.2%, 19.4% and 12.1% respectively.

The quarter was characterised by two key features: a strong performance from domestic banks (in contrast to a weak performance from the life insurance sector) and continued weakness in the pound as investors try to figure out exactly how and when Brexit is going to happen. (Subsequent to quarter-end, Theresa May has committed to the timing of what is increasingly being seen as a ‘hard Brexit’. Unsurprisingly, this doesn’t seem to have helped at all.)

Banks returned 10% for the quarter, after reporting results to June that were generally better than expected. Revenue growth has been decent, margins have expanded slightly, credit losses have increased somewhat but remain reasonably benign for a tough environment, and cost control has been good. Domestic banks make up three of the top five holdings in the fund (Investec is another), and performance benefited as a result. In contrast, life companies returned -1.5% for the quarter, after reporting results that were characterised by slowing new business, lower mortality profits and pressure on asset management earnings.

Weakness in the pound has detracted from performance. Over many years we have consistently sought to build geographic and currency diversification in the fund (where valuations are appropriate). This has resulted in meaningful exposure to both Old Mutual and Investec, and to a lesser extent to UK property stocks. While these companies have roughly held their value in sterling terms for the quarter (after a dramatic sell-off in June, in the case of the property stocks), sterling weakness has resulted in negative returns when measured in rand terms.

Specifically, positive contributors to performance during the quarter included overweight positions in Nedbank, Standard Bank and Coronation, as well as a lack of exposure to underperformers Brait and domestic property stocks. Detractors from performance included overweight positions in Discovery, Investec, Capco and Old Mutual, as well as having had no exposure to Sanlam.

We have been relatively active in the portfolio during the quarter, exiting positions in Barclays Group Africa and Zeder, and reducing the fund’s holding in Coronation. With the proceeds of these disposals we have increased exposure to Investec, and initiated positions in Liberty Holdings and Ethos Private Equity. In addition, we have switched some of the fund’s exposure from Intu into Hammerson, and have also funded the Hammerson position with inflows into the fund.

The negativity around UK property stocks presents an interesting opportunity in our opinion. In total, 6.6% of the fund is exposed to this sector in the form of three stocks: Hammerson, Intu and Capco. Hammerson and Intu own and operate portfolios of retail shopping centres, while Capco is a property development company with exposure to both retail and residential assets. The long-term implications of Brexit on the UK economy - and especially the London housing market - remain uncertain, but it seems likely that people will continue to shop. Prime location shopping centres are scarce assets, where the potential for an increase in supply is extremely limited due to planning restrictions.

Hammerson, recently listed on the JSE, is in our view a superior business to Intu. This is due to the diversity of assets in its portfolio (30% of which comprises Irish and French retail centres) and the fact that it has a better track record of net asset value (NAV) growth. This quality comes with a more demanding rating, however, and we have therefore split the fund’s exposure between the two. The Capco share price has suffered most as a result of prevailing negativity, due to its exposure to residential development assets and land. However, 60% of its value sits in its development of retail assets in the Covent Garden area. This is predominantly a tourist shopping destination, and if anything is likely to benefit from pound weakness as travel to the UK becomes cheaper.

All three of these businesses trade at discounts of between 20% and 30% to their most recently stated NAVs. NAVs naturally incorporate many assumptions, and these need to be tested. Our assessment is that the fair values for these businesses lie within 10% of their stated NAVs. The UK economy and currency no doubt face a period of great uncertainty and volatility in the months to come, and for this reason we have limited the position size. However, over the long term, we are hopeful that these stocks will contribute meaningfully to performance.

Operating conditions for businesses in the SA financial sector remain challenging. Weak economic growth and pressure on employment and real wage growth are likely to impact negatively on asset growth and impairments in the case of banks, and new business volumes and persistency in the case of insurers. In addition, it appears that we are approaching the top of the interest rate cycle, which will bring an end to the tailwind of endowment earnings that the banks have enjoyed. Offsetting this to some extent is the fact that earnings growth expectations are not heroic, and valuations are not particularly demanding.

Portfolio managers Neill Young and Godwill Chahwahwa as at 30 September 2016

The fund returned 4.8% for the quarter, compared to a 6.2% return for the index. Over more meaningful periods of three, five and 10 years the fund has delivered compound annual returns of 15.8%, 18.7% and 13.7% respectively. The benchmark has returned 16.5%, 19.8% and 12.8% over the corresponding periods.

The quarter has been an eventful one for investors. Markets declined in the first half of the period, in part reflecting concerns around the impact of a tightening US interest rate cycle into what remains weak global growth. However, an increase in quantitative easing by the European Central Bank and clear indications from the US Federal Reserve that interest rate hikes will be gradual reversed much of this, and most developed markets ended the quarter roughly where they started off. In the UK, the debate around Brexit impacted negatively on both the market and the currency (some of which has been felt in the portfolio), while a bounce in commodity prices and oil has benefited emerging markets.

Domestically the fraught political environment has resulted in ongoing rand and bond market volatility. The JSE All Share Index ended the quarter up 3.9%. Banks returned 13% and the life insurance sector produced 5.6%. Interestingly, bank share prices have been supported by net foreign investor buying amounting to R2.4 billion during the period. One of the key issues for investors remains whether or not South Africa will suffer a credit rating downgrade later in the year. From where things stand at the moment, we think it is more likely than not.

The financial sector has had an eventful quarter from a corporate action point of view, or at least the promise of it. Barclays plc announced its intention to sell down its 62% stake in Barclays Africa Group (previously ABSA) to a level where it is no longer required to consolidate the bank for accounting or regulatory purposes. This means it will reduce its shareholding to somewhere below 20%. This, we believe, creates a number of longer-term challenges for the local bank, not least with respect to the use of the Barclays brand in Africa outside of South Africa, access to the larger group's IT systems, and leveraging off the plc's skills base - particularly in the investment banking division.

At the same time, Old Mutual announced its intention to break up the group to allow its component parts to stand alone - i.e. an emerging markets life business, a bank (Nedbank), a UK wealth business and a US asset manager. We have long felt that the group's UK listing and conglomerate structure were not in the interest of shareholders. Very few synergies exist between the various businesses, and the centre costs and capital requirements suffered were unwieldy and unnecessary. This is a process that will take some time to come to fruition, but each of the businesses is attractive in its own right, and in the fullness of time we expect value to be unlocked. Old Mutual trades on a 12-month forward PE of about 10 times, which we think understates the quality of the assets. Old Mutual is the fund's largest holding at 14% of fund. The biggest contributors to fund performance for the quarter were holdings in Coronation, MMI, Liberty, Sygnia and Santam. The most meaningful detractor was the fund's holding in Capital & Counties, the UK property development stock. This is an investment that has served the portfolio well over many years (in fact, it is the top contributor over three years), but sold off sharply in the quarter largely in response to fears around Brexit, as well as concerns around softness in the London residential market. The share trades at an attractive 9% discount to stated NAV, and we continue to believe that it adds valuable diversification benefits to the portfolio. Holdings in Discovery and Investec also detracted, as did the fund's lack of exposure to Sanlam.

The South African domestic economy faces a challenging time in the year ahead. Growth is weak, the consumer is under pressure with inflation and interest rates on the rise, and political wranglings do little to instil confidence. The outcome of the credit rating review in June will have a more immediate impact on financial institutions, particularly on the banks' cost of funding. That said, PE and PB (price-to-book) multiples of these banks are relatively low, capital positions and provisions are healthy, and they stand to benefit from the endowment impact of higher interest rates. The life companies will likely face a challenging new business environment, persistency will be under pressure and as always these businesses are inherently sensitive to equity and bond markets. In summary, we expect the sector to face a testing time operationally, but feel that a good deal of this is already factored into share prices.

Portfolio managers
Neill Young and Godwill Chahwahwa

The financial sector returned -3.3% in an eventful final quarter of 2015, and 3.9% for the year. Over corresponding periods the fund returned -5.0% and 0.4% respectively. The annual number is disappointing, and one needs to go back as far as 2006 to find a year in which the fund underperformed its benchmark by a greater magnitude. While the fund underperformed all of its competitors in that year, it still delivered 29%, so the blow of underperformance was somewhat offset by attractive absolute and real returns. At the time of writing, it looked as though the fund would end the year 2015 as a second quartile performer, yet has only narrowly avoided losing money. The reasons for this we discuss below.

The fund performance of 2015 has impacted on the more meaningful longer-term returns, to the point that three-year returns have retreated to being roughly in line with that of the benchmark. Over three, five and 10 years, the fund has delivered compound returns of 16.3%, 17.4% and 14.4% against sector returns of 16.4%, 18.5% and 13.7% respectively.

The month of December witnessed three significant events that impacted meaningfully on the performance of our market, and the financial sector in particular. On December 4th, S&P downgraded its outlook for SA while at the same time Fitch cut its rating one level - both actions effectively placing our debt a single notch above junk status. On December 16th, the FOMC raised the Fed funds rate for the first time since 2006, confirming a slow but nonetheless sustainable US economic recovery. Both of these actions were well flagged and the likelihood of their happening was factored into the construction of the portfolio. What we did not anticipate was what transpired in the middle of all of this: the dismissal of SA's minister of finance, which sparked a collapse in the bond and currency market. The subsequent about-turn meant that the risk of a run on the banks was averted, but the carnage in the bank sector in the two days following the initial announcement was brutal, selling off 18%. The reappointment of Pravin Gordhan did calm nerves somewhat, but the negative effects still linger: bank share prices remain depressed and the currency continues to weaken.

Needless to say, the fund's overweight position in banks has detracted from performance as a result. The bank sector declined 12.8% for the year, all of which effectively occurred in the final quarter of 2015, and 10.8% of which happened in December alone. Our view on the banks has been predicated on a moderately rising rate cycle, well provisioned balance sheets and solid capital positions, as well as attractive growth prospects in their 'rest of Africa' operations. Generally we think these assumptions still hold, although the risks of a weaker economy impacting more severely on asset growth and impairments, as well as a more sharply rising rate cycle in response to inflation resulting from a weaker currency, cannot be discounted. In addition, any downgrade of SA government debt to junk status will impact on the ratings of the banks' paper, which will flow through to equity valuations too. Share prices have retreated sharply, however, and SA banks now trade on forward p/e multiples of 8-9x and dividend yields of 5-6%, which we think discount some of these risks.

Not owning domestic property stocks has also cost the fund in performance terms. After a number of years of strong returns and new listings, the sub-sector now makes up 28% of the benchmark. For the year, the listed property sector returned 8%. The fund does however hold meaningful positions in the UK property stocks Capco and Intu, and these contributed to performance.

Life companies outperformed banks for the quarter and for the year (in the latter case significantly) with returns of -6.2% and 7.5% over the respective periods. Amongst these, the top performing stocks were Old Mutual and Discovery, both of which are well represented in the fund. The risk of rand depreciation is something that we have actively tried to protect against where possible by owning businesses that derive a meaningful proportion of earnings from non-SA sources. Specifically these are the fund's holdings in Capco, Intu, Reinet, Investec and Old Mutual, which together constituted 38% of the fund at the year-end. These holdings have helped to cushion against the impact of rand weakness.

Significant contributors to performance during the quarter were overweight positions in Sygnia, Investec and Capco, while not owning any shares in Brait coupled with overweight positions in Nedbank, Standard Bank and HCI detracted. The same stocks dominated the one-year performance attribution, as well as contributions from an overweight position in Discovery and not owning Sanlam, while the fund's holding in MMI detracted. We expect 2016 to be a tough year for the sector. The global economy faces the challenges of a slowing China, asynchronous monetary policy and rising geopolitical tension. Domestically we face the unwelcome combination of a slower growth environment, coupled with rising inflationary pressures, in addition to the increased SA risk premium brought about by the events of December discussed earlier. Offsetting this somewhat is greater safety in valuation following the sell-off. Against this backdrop we remain cautious in our outlook for financial sector returns, but continue to hunt for new ideas and to reward investors for their ongoing support.

Portfolio managers
Neill Young and Godwill Chahwahwa